Reverse Mortgage or Reversal of Fortune?

Posted: 11/05/2009 - USAA

New rules for reverse mortgages make them more attractive, but proceed with caution.

Confronted by market-damaged retirement portfolios, increasing life expectancy and high health care expenses, many cash-strapped retirees are turning to reverse mortgages to squeeze spending money out of their home. While new federal rules are making these tools more flexible than before, make sure you've considered the pros and cons before taking the plunge.

The Fundamentals

When you think of mortgages, you probably think of people borrowing money to buy a house and then making principal and interest payments to pay off what they owe. Over time, their home equity — or the difference between their property value and their shrinking mortgage — grows.

As the name implies, reverse mortgages turn that scenario upside down:

* They're typically used by people who already own their homes free and clear and who want to turn their home equity into spending money. They do that by taking out a loan that's secured by their shelter.
* Over time, their equity steadily shrinks, because reverse mortgages require no payments at all. Rather, interest accrues and is repaid when you eventually sell the home, move out or die.

Reverse mortgages are only available to homeowners who:

* Are 62 and older (a restriction that applies to everyone on the deed)
* Use the home as their primary residence
* Owe nothing else on their home

The amount you can borrow depends on your age, the value of your home and interest rates — the higher the rate, the less you can borrow. For an estimate of how much you might be able to tap, try this calculator from the National Reverse Mortgage Lenders Association.

What's Changing

Recent federal action has brought three key changes to reverse mortgages:

* They're now available for new purchases. For the first time, you can use reverse mortgages to finance the purchase of a home. Previously, some retirees used conventional mortgages to purchase their homes and immediately paid them off with a reverse mortgage. This change eliminates the extra expense associated with that two-step technique.

* Higher limits. Effective Jan. 1, 2009, the maximum amount you can borrow using a reverse mortgage has increased to $417,000. (Higher limits may apply in Alaska, Hawaii, Guam and the Virgin Islands.)

* Lower fees. Loan origination fees are now limited to:
o Only 2% of the home's value up to $200,000
o An additional 1% of the value above $200,000
o A maximum of $6,000

These changes make reverse mortgages more attractive, but — like any major financial commitment — they should still be approached with caution. Indeed, given what's at stake, reverse mortgage applicants must receive counseling from an agency approved by the U.S. Department of Housing and Urban Development.

Using Them Wisely

How can you tell if a reverse mortgage is the right move for you? USAA CERTIFIED FINANCIAL PLANNER practitioner J.J. Montanaro offers this advice.

* Carefully assess your needs. "Before assuming you need a reverse mortgage, crunch the numbers," says Montanaro. "Factor in your expenses and all your sources of income, including an estimate of what you'll get from Social Security." USAA's Retirement Income Planner makes it easy.

* Weigh your options. There are other ways to address a cash crunch. If you're not sure if your money will last as long as you do, a guaranteed income annuity may squeeze more income out of your savings. Or you may be better off using a home equity loan or selling your home and renting another one.

* Consider your time horizon. Avoid reverse mortgages if you're not sure how long you'll stay in your home. "While origination fees are lower now, they're still pretty high and usually well above a conventional loan," says Montanaro. "You should be confident you'll be in the home long enough to justify the expense."

* Shop around. To make comparisons easier, reverse mortgage lenders are required to provide you with a Total Annual Loan Cost, known commonly as the TALC. The TALC is calculated over several time periods, and the results underscore the importance of using reverse mortgages for long-term needs only. And remember — while most origination costs can be added to your loan balance, that's money you and your heirs will never see again.

* Duck aggressive sales pitches. The North American Securities Administrators Association recently cautioned consumers about aggressive salespeople suggesting reverse mortgages to fund investments. "Never take out a reverse mortgage with the idea of making a killing with the money," says Montanaro.